Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Friday, May 4, 2012

A reply to David Beckworth

If potential GDP is what the CBO says it is, then the U.S. economy seems to be stuck in a rut. Proponents of NGDP targeting generally believe this to be the case. They also believe that were the Fed to adopt a credible NGDP target right now (with the NGDP path targeted back to its original path), then this NGDP path would become self-fulfilling. Moreover, they believe that the transition path back to normality would mostly take the form of RGDP growth (with perhaps a temporary blip up in the inflation rate).

I wish I could believe this too. But before I can, I have to find out what combination of logic and evidence underlies this belief. David Beckworth, a strong proponent of NGDP targeting, has kindly directed a reply to my query here. I'd like to offer a quick reply to the defense that he offers.

Theory

David quickly outlines two creditor-debtor problems that a NGDP target would help overcome.

The first problem is restoring the expected relationship between creditors and debtors that prevailed prior to the economic crisis. This is the 'risk sharing' problem recognized by David Andolfatto that a price level or strict inflation target cannot address. A NGDP level target would solve this problem by restoring nominal incomes to their expected pre-crisis paths when debtors signed their nominal debt contracts.

This is the "fairness" issue that talked about in my previous post here. In that post, I suggested that this problem may not be so significant because the price-level seems to be pretty close to its pre-crisis path (at least, if one draws the log linear trend beginning in 1990). But maybe I am missing something because evidently this "is a problem that price-level targeting cannot address." I presume this means that what is needed (given the current price-level) is more RGDP--and more RGDP in the form of greater employment, not productivity. Sure, but how is a nominal target supposed to increase RGDP? And what does restoring RGDP have to do with this "risk-sharing" argument? Of course creditors would like to see their unemployed debtors get back to work and service their debt. This has nothing to do with risk-sharing, as far as I can see.

The second problem is that there is a massive coordination failure among creditors now. Creditors could increase their spending to offset the debtor's drop in spending as the latter deleverages. The reason creditors have not--non-bank creditors are sitting on money assets while bank creditors are destroying them as they are acquired from the deleveraging debtors--is because they are uncertain about future economic activity. These actions by creditors create an excess demand for money or, equivalently, a shortage of safe assets.

David is not being as careful with his language as he should be: he cannot be anywhere near certain that the coordination failure he alludes to actually exists. It is only one of many different interpretations of current events. (An interpretation to be taken seriously, but not stated as if it were obviously true, and the reader obviously dense should he/she not see its veracity. Sorry, just a pet peeve of mine.)

As David knows, I have a lot of sympathy for the "asset shortage hypothesis" (I have written about it here, for example). In fact, any model that has a limited commitment friction that gives rise to debt constraints has a version of this idea embedded in it (this includes all New Monetarist models). The policy prescription coming out of these models is to expand the supply of "high quality" assets to meet the shortage. (Note, however, I have not seen anyone employ sticky nominal debt in these frameworks--would be worth exploring). The most obvious candidate here are U.S. Treasuries, which are used extensively as collateral in repo arrangements and as stores of value. Precisely how the Fed could improve this situation by removing these assets from the market (replacing them with assets that are roughly equivalent -- zero interest cash) needs to be spelled out more clearly. (David possibly has in mind the purchase of private assets, but this is not generally permitted under the Federal Reserve Act. In any case, why not have the Treasury issue bonds to finance the same purchases? Not sure what any of this has to do with a NGDP target).

Evidence

Okay, so what is the empirical evidence that a higher level of NGDP would make a difference now? The most obvious answer is that those advanced economies currently doing the best are the ones where aggregate nominal spending has remained on or near its pre-crisis trend. Case in point is Germany.

It is true that Germany largely escaped the world recession. But was this because agents around the world believed that German NGDP would not depart significantly from its path? Or was it because Germany had no real estate boom/bust episode? This is not evidence that stable NGDP prevents a crisis; it is evidence that avoiding a crisis prevents a decline in NGDP. We need to establish a direction of causality here, before making strong claims about what is happening.

A final but important piece of evidence is FDR's very own QE program in 1933. He had publicly called for the price level to return to its pre-crisis trend and then backed up the rhetoric with a devaluation of the dollar (relative to gold). As Gautti Eggertson shows, this policy dramatically altered expectations and sparked a robust recovery in 1933. This implicit price level target of FDRs was no different than a NGDP level target in this case.

Well, O.K. Although, I'm not sure one would want to compare the decline in the price-level in the early 1930s with what just happened recently; again; see the diagram here.

More theory

A NGDP level target would do the same today. It would commit the Fed to buying up as many assets as needed to restore aggregate nominal spending to some pre-crisis trend. Just the expectation of the Fed doing that may itself cause the market to do much of the heavy lifting.

The Fed is currently restricted to purchasing U.S. government bonds and agency debt. As such, the Fed has control over the composition of the total U.S. government debt outstanding (the composition between low-interest cash and higher-interest bonds). Under present conditions, I do not think that this composition matters very much (though I could be wrong). Perhaps David is urging Congress to expand the set of securities available for open market operations? If so, does he see any potential political problems with that? (The answer should be "yes")

And what about this idea that the expectation of higher NGDP itself bringing about its own fulfillment? I know that Nick Rowe has gone on about this here and elsewhere. I think I'll need a separate post to investigate this claim.

In the meantime, here's a question for the NGDP proponents. I think that most people might agree that the Fed has built up a big stock of reputational capital designed to anchor a 2% inflation target. It may not be the perfect policy rule, but most societies around the world could only wish for such credibility in their monetary authorities. What if the Fed decides to adopt the proposed NGDP target, and fails? What then? What does that do to Fed credibility? Have you worked it out? Or does the solution concept you employ always rely on a self-fulfilling rational expectation?

There is something else. Whether we like it or not, policymakers are not indifferent to the composition of NGDP.

Adopting a NGDP target implies that policymakers can commit to (say) a 5% NGDP growth rate. But what if inflation turns out to be 4% and RDGP growth turns out to be 1%? (Or how about 7% inflation and -2% RGDP growth?) A credible NGDP target implies that policymakers remain committed to the 5% NGDP growth rate. But ask yourself this: Do you really believe that policymakers would leave policy unchanged in this circumstance?

First, a NGDP level target would address the safe asset shortage problem the following ways. One, by improving the economic outlook it would decrease the demand for safe assets. Investor would be willing shift their portfolios into riskier assets Two, by improving the economic outlook it would lower the risk premiums and make it easier for the private sector to produce safe assets. There are a number of papers that empirically demonstrate that the public production of safe assets substitutes for the private production of them. A NGDP level target makes it easier to get the private production of safe assets going again and at the same lowers the demand for them.

Second, one of the big advantages of a NGDP level (not growth rate) target is that it anchors expectations of future nominal spending. For example, if a credible one had been in place in 2008 it is unlikely nominal spending expectations would have deteriorated as much as did and that in turn would have kept current nominal spending more stable. The point is that the Fed would not need to buy a whole lot of assets under such a rule.

But let's say the Fed had to buy up more assets. There are still plenty of treasuries and GSEs available and the Fed can also buy up foreign exchange. Just imagine if the Fed announced it was going to buy up these assets until the NGDP hit some growth path? How do you think the market and ultimately the economy would respond? They would automatically price it in and adjust their forecast of future nominal incomes. I think FDR's experiment provides a good answer.

Third, I believed I already answered your question about the downside of NGDP in the post. Let me quote what I said there: And what is the downside? What if adopting a NGDP level target does not improve the economy? The upshot here is that with a level target there is still a strong nominal anchor in place. The NGDP level target allows rapid catch-up growth (or contraction) in nominal spending without causing long-run inflation expectations to become unmoored. Thus, there is far less risk in trying NGDP level targeting than many observers assume.

Fourth, the point about Germany other countries that kept NGDP from falling is not about whether they had a real estate boom or not. The point is that in these countries it must have been the case that expectations of future NGDP and future nominal incomes were kept stable otherwise residents in these countries would have cut back spending in anticipation of a decline in NGDP and nominal incomes. Somehow policymakers kept nominal expectations anchored and as result NGDP did not crash. A NGDP level target would do the same.

Finally, just because one has a real estate boom is does not follow that there must be an economy-wide recession. The U.S. went about two years after the housing recession started before it turned into a national one. During this time the Fed did keep NGDP expectations anchored. Only when it let them fall in mid-2008 did we begin to see a truly national collapse. See my post here on this point: http://macromarketmusings.blogspot.com/2011/12/what-really-caused-crisis.html

[1] You can repeat "a NGDP target will improve the (real) economic outlook" as much as you like; it will never be able to convince me with explaining how it is supposed to do this.

Btw, you did not really answer my critique of your view of the "safe asset problem" and of your allegations of "coordination failure."

[2] Granted, a credible NGDP target provides a nominal anchor. Whether this is the panacea it is made out to be, I'm not sure (especially in terms of how adopting such a target right now might help).

[3] Sorry about that, I was too rushed. Yes, perhaps the downside risk of adopting the target is limited. My own view is that it would largely be innocuous and distract attention away from where the real problems lie.

[4] You have your direction of causality reversed, imo. You need to establish a direction of causality. This is hard to do. And yet, somehow you believe it. I am more agnostic.

dwb, no, I do not believe I am saying that. I am claiming [4] is an assertion, not a fact; and that [4] I believe the direction of causality is reversed (higher real GDP causes higher nominal GDP, conditional on policy, rather than the other way around).

maybe its phraseology. I am not reading [4] as a causal relation and to me it sounds like you are saying agents do not form expectations of future output and inflation (I would strongly disagree with that statement).

Maybe you mean, its not clear to you that those expectations were anchored (no one can really prove intent CB are notoriously cryptic)?

Lets not talk about causality for a second and lets take for granted that agents form expectations of future output based on future prices and costs (which may or may not be somewhat rigid in the near term). Lets also take for granted that the CB could anchor those expectations.

Seems to me the correct phraseology of your question is more like: 1)to what extent are wages/prices inflexible; 2) under what conditions (of wage, price flexibility) is nominal income targeting superior to flexible inflation targeting (ala the Taylor rule) or simple inflation targeting.

That is, suppose the CB changes the money supply (again for arguments sake, we could do the same experiment in an ISLM model with interest rates).

Some flows to output, some to the price level, depending on nominal rigidities. I don't think its a "causality" issue per se, its a statement of the flexibility of prices/costs, the neutrality of money, and how agents respond to those inflexibility by planning more output in light of those rigidities.

So, I would disagree with the statement that higher rdgp causes higher ngdp (or vice versa) and I don't really thinks that's what is meant here.

Its more like an implicit statement of (empirical) money neutrality (or the Phillips Curve if you prefer) in these examples (how much stimulus shows up in output/prices) and whether the CB can anchor expectations.

which is why it sounded to me like you were denying that the CB could anchor expectations.

I do believe that a credible central bank should be able to anchor expectations over NOMINAL variables. I believe that a central bank has much less control over determining real variables, especially in the long-run. If we are indeed on a lower long-run growth path, as evidence from the NY Fed seems to suggest, then there is little that anchoring nominal expectations can do about it.

I do believe it is a question of causality. Sumner and Beckworth want us to believe that increasing nominal GDP will increase real GDP, and that the data supports this proposition. I argue that the direction of causality is reversed, and that the data supports my proposition.

End of the day: I'm not sure. And I'm not sure how they can be so sure.

I come at it from a different perspective. First credibility, then how ngdp targeting might be different from the current policy, then how i see QE as working presently.

1. credibility, I think you are confusing desirability with credibility. I dont think you doubt that the fed could hit a 15% ngdp growth target first by monetizing all the treasury debt, then by mbs, then dropping $1000 randomly into checking accounts until we got 15% nominal growth. I think you are questioning the Fed's willingness to stick to such a policy in the face of obviously undesirable 13% inflation and 2% growth. It boils down to willingness and a reasonable target.

Credibility is a function of proper framing with wiggle room. The Fed fails at 2% pce each and every month, is credibility diminished?

I think you should assume the fed WILL fail – plan for the unexpected to happen. Its also reasonable to assume that the ngdp growth path will change over time with demographics, supply side tax issues, and so on. so what? What if the Fed framed it as "we are targeting a 4-5% growth band, and allow deviations to the extent they are consistent with long run estimates of potential output and price stability, but aim to minimize total deviations from the trend path over the medium term. We review our band annually, and any changes to the band would be implemented over the long term policy horizon."

Also, I do not have the same perspective on credibility that you do. in the 60s and 70s, the Fed put a lot of weight on output and none on inflation. In the 80s and 90s it established credibility on inflation. More recently, judging from the press conference reaction and TIPS spreads below 2%, there is lots of credibility on inflation and zero on output, and even the 2% is seen as a ceiling. I think *both* parts of the mandate should have full credibility at all times. But at times one half has not, without social collapse.

2. On how the reaction function might be different from the current regime, I dont see a radical departure, more a natural improvement over current policy, cementing a commitment to minimize output variablity around trend. First, the outcomes from a reaction function using a balanced forward-looking Taylor rule (ala Bernanke's Jan 2010 testimony) are strongly correlated with a reaction function merely using ngdp gap (see graph #1, FED only has TIPS going back to 2003).

Thinking again from a 30,000 foot view this makes sense if you think of ngdp targeting as minimizing the variance of p*y.

I see the current policy as a lesser cousin of ngdp targeting (see link #2 the dallas fed paper, cant recall if you saw it).

So, how is ngdp targeting different? Well, for one, it minimizes the variance over the whole path (say, 5 years), which implicitly means that excess growth is "borrowed" from the future and vice versa.Legend has it Greenspan was actually following an implicit ngdp rule, so again I dont see this as a radical policy experiment, more like an ackowledgement of longstanding policy.

As far as what the target is, we can debate whether 3%,4%,5% is the right target (and how much of the output gap to make-up), but i don’t really think its about ability. The main thing is to pick a target like 4% that minimizes caustic effects of ngdp declining - which is where you get debt-deflation, consistent with long-run price stability.

3. So as far as the way QE works, i see that a lot of people think that the fed has wavered (or outright abrogated) its commitment to the employment side of the mandate, so QE works by cementing its commitment to that side of the mandate.

But even so, i still think of ngdp targeting as fundamentally about the Fed committing to minimize the variability in trend growth over some medium-term horizon. inflationary, above trend growth will be matched with below trend growth in the future (and vice versa, its important that the commitment is symmetric).

the *primary* way this works is through expectations. There are, of course, a myriad other real channels, like lowering long term rates, wealth effect etc., providing more safe assets (i.e. if the Fed bought long term assets and sold short term assets through "sterlized QE").

but i think the #1 effect is to reduce trend output uncertainty which ultimately means the Fed could reduce its balance sheet sooner. Any initial purchases would just be to prove its serious.

"I think that most people might agree that the Fed has built up a big stock of reputational capital designed to anchor a 2% inflation target. It may not be the perfect policy rule, but most societies around the world could only wish for such credibility in their monetary authorities."

Most societies around the world would probably rather prefer a monetary authority that has the competence to spot an $8 trillion residential real estate bubble before it bursts and wrecks the economy, rather than a monetary authority that has built up a credible 2% inflation target.

Most societies around the world would probably rather prefer a monetary authority that has the competence to spot an $8 trillion residential real estate bubble before it bursts

the Fed and OCC clamped down on liar loans in 2006; by 2008 delinquencies were 50% higher than 2000-2007 average and housing starts had plummeted. We were 18-24 months into the housing downturn when output fell off a cliff in late 2008.

Have you forgotten the real estate mess in the 80s, or 90s? Does "Continental Illinois" ring a bell? maybe you forgot because real estate bubbles and stock market crashes do not need to lead to Great Recessions if the Fed stabilizes nominal income.

I think its better to think of the housing "bubble" as a severe distortion in the relative price of owner-occupied housing vs renting due to stupid lending (financing was too cheap on owner-occupied). It was not housing demand per se - rents are going up, people still need to live somewhere, and we have tens of millions more people in the last 4 years. There is plenty of demand for housing!

No, the fundamental issue is that if nominal income is allowed to actually decline, delinquencies get *much worse* and this precipitates and banking crisis.

The PCE deflator is back to its trend level; inflation expectations are normal; corporate profits are at peak; business investment has been robust; asset price risk spreads representing the outlook for broad swaths of the economy are in normal ranges. This doesn't point to the existence of generalized, abnormal uncertainty over AD.

Imagine the G7 deficit-to-gdp and debt-to-gdp ratios were 3% and 50% respectively. Monday, the G7 announce a $3tr forced, fiscal recapitalization of the global banking system, along with stringent loss recognition rules and a quick, credible path to re-privatization (the Nordic/Chilean restructuring model). Additionally, TBTF banks would be broken up and Glass Steagal reinstated.

After such a G7 move, would there be excess demand for safe assets?

Arguably, we had half of our "FDR moment" (vanquishing deflation expectations). Now we just need the other half.

a somewhat unsatisfactory debate, since we really dont have any good theory or history to tell us if NGDP targeting would boost us out of depression or not. But what's the worst that could happen ? Might as well give it a try. That's what economic policy is all about - trying things out to see if they work.

Let me add this in favor of David Beckworth's nominal achnor argument.

There is no guarantee that there will be some real interest rate greater than negative 2% which will leave the marginal agent satisfied with the tradeoff between current and future expenditure. Under a commodity standard, this wouldn't necessarily be a problem, because, if the marginal agent still prefers future expenditure at a nominal interest rate of zero, she can bid up the current value of money relative to the future value until the real interest rate is negative enough to leave her indifferent. If, however, the central bank credibly promises a predetermined rate of inflation, then there is a floor on the real interest rate, and there is nothing to ensure that market will clear. If the equilibrium nominal interest is negative under these circumstances, credibility is a bug, not a feature.

Now if, instead of promising a predetermined inflation rate, the central bank promises to return always, as soon as it can, to a predetermined path of nominal GDP, you may still get a temporary disequilibrium, but you can at least be confident that the disequilibrium will eventually resolve itself. As the actual path diverges from the target path, the inflation rate necessary to return to the target path will rise, and accordingly the real interest rate will fall, and it will continue to fall until it is low enough to clear the market, at which point there will begin to be excess demand for current output, eventually driving the inflation rate up to a level that will allow nominal GDP to return to its target path.

For the sake of argument, I have assumed that prices and wages are flexible, and if you believe that, then my argument for NGDP level path targeting is equivalent to an argument for price level path targeting. For the many economists who believe that price and/or wage rigidities are important, the case for NGDP targeting is stronger, because, for one thing, periods of extremely low equilibrium interest rates are likely to coincide with severe recessions and the aftermath thereof. That's a happy coincidence under NGDP targeting, because it means that, even if prices are slow to respond to weak demand, NGDP will be below target at precisely those times when the equilibrium interest rate is very low, thus increasing the chance that a market-clearing real interest rate will be immediately feasible.

That means that the fed could target a slightly lower rate of ngdp growth, because by committing to minimize the variability of nominal output, make up growth, etc, a lower deflation insurance premium is necessary. So I think its possible, for example, to get a 1-1.5% long run inflation rate rather than 2%. I also think by removing the risk a slightly raises the long run growth potential. So I think its quite the opposite: ngdp targeting could actually lower the long run trend inflation rate.

I'm not sure about the risk sharing argument, but I think there may be a case for risk *reduction*. We don't really have a very good theory of the level of the short rate, but it strikes me as not totally crazy to assume that if NGDP growth was stable at 5% (lets say as stable as inflation has been in the past 10 years), that long term yields and, to a somewhat lesser extent, the short rate would be stable at something very close to 5%. This would reduce the probability of extreme surprise debt/income outcomes (especially the kind that can occur at the ZLB) which ought to be welfare enhancing. What do you think?

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